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∗ ETH Zurich
† Universityof Amsterdam Faculty of Economics
This paper is posted at the eScholarship Repository, University of California.
http://repositories.cdlib.org/blewp/art180
Copyright
2006
c by the authors.
A Legal Options Approach to EC
Company Law
Abstract
In recent years, legal options (ex ante and ex post choices created by law)
have gained acceptance in the European Union. Notwithstanding the move to-
ward soft law measures, the EC’s appetite for options or pro-choice company
law provisions remains unclear. There are significant barriers to the EC’s abil-
ity to promote efficient regulatory choice due to interest group pressures, diffuse
control over the agenda-setting process, and a limited capacity to anticipate and
meet a wide range of Member State demands.
This article shows that bringing options to the forefront of company law reform
can reduce costs for small and medium-sized firms and provide clear benefits to
companies that differ in their ownership and control structure from most large
public corporations. Switching to a company law regime with different sorts of
options can have a good effect on stakeholders as well. As a regulatory strategy,
we advocate a step-by-step change, beginning with the adoption of a limited
number of opt-in provisions.
A Legal Options Approach to EC Company Law
In recent years, legal options (ex ante and ex post choices created by
law) have gained acceptance in the European Union. Notwithstanding
the move toward soft law measures, the EC’s appetite for options or
pro-choice company law provisions remains unclear. There are
significant barriers to the EC’s ability to promote efficient regulatory
choice due to interest group pressures, diffuse control over the
agenda-setting process, and a limited capacity to anticipate and meet
a wide range of Member State demands.
This article shows that bringing options to the forefront of
company law reform can reduce costs for small and medium-sized
firms and provide clear benefits to companies that differ in their
ownership and control structure from most large public corporations.
Switching to a company law regime with different sorts of options can
have a good effect on stakeholders as well. As a regulatory strategy,
we advocate a step-by-step change, beginning with the adoption of a
limited number of opt-in provisions.
*
Professor of Law, Swiss Institute of Technology (ETH Zurich).
**
Professor of Corporate Governance and Business Entrepreneurship, University
of Amsterdam Faculty of Economics and Econometrics. He is also Goldschmidt Visiting
Professor of Corporate Governance at the Solvay Business School (Brussels), and
Professor of International Business Law, Tilburg University Faculty of Law. The authors
thank Richard Buxbaum, Aaron Edlin, Luca Enriques, Jesse Fried, Amir Licht, Erik
Vermeulen and seminar participants at the Law and Economics workshop at the
University of California at Berkeley Law School and conference participants at the
Tilburg University Conference on Real Seat Transfers and Reincorporations in the EU for
helpful comments.
2 Gerard Hertig and Joseph A. McCahery
A. INTRODUCTION
Legal options are not a new thing. For many years, default rules and a
variety of option techniques have been used in a wide range of
contexts. More recently, default rules have been used in the US, for
example, to accommodate the diversity in organization, capital
structure, and lines of business. They clearly are a dominant strategy
for governments that want to facilitate innovation and supply a set of
rules that appeal to different business parties’ preferences. Perhaps
more importantly, a default approach can supply small and medium-
sized firms with rules that can provide value by lowering formation
and operation costs. Unlike mandatory rules, which are necessary
under certain conditions to ensure financial disclosure, limit collective
action problems and protect shareholders’ and creditors’ interests, the
terms specified in a default rule are not immutable. With default rules,
parties are free to opt out and choose among different rules.
Economic theory has emphasized that, where contracts are
silent or incomplete, options provide firms with an array of contractual
terms on particular subjects (such as capital contributions, dividend
rate, management remuneration and tenure) that encourages efficient
contracting. Options provide a framework that allows parties to reduce
information problems and lower the cost of contracting that they
otherwise would have to pay. Default rules, in particular, can enable
shareholders to protect themselves from managerial opportunism by
simply relying upon rules that presumptively are biased in their favor.
There is some debate as to whether options provide a promising
alternative to corporate law regimes based on mandatory rules. On the
one hand, there are a number of situations where a mandatory rule
would benefit shareholders against the self-interested conduct of
insiders. There can also be some circumstances where a mandatory
rule may be desirable to protect third parties. Further, a switch to an
enabling regime may impose excessive costs for firms that cannot
simply opt out and into a legal regime that is consistent with their own
interests. On the other hand, an options approach can ensure that
Legal Options Approach to EC Company Law 3
approach in Europe.
The EC has built a record of company law reform that enjoys a mixed
reputation. Early legislation has been praised for quickly developing a
company law infrastructure that was in some important respects
similar to the corporate law structures in most Member States. Second,
the Commission was successful in implementing laws that facilitated
cross-border trading by minimizing the risk of companies or their
transactions being considered void in other Member States. Third, the
adoption of accounting and capital maintenance rules aimed at
protecting minority shareholders and creditors secured some
enthusiasm for Commission efforts in devising mechanisms dealing
with financial assistance and disclosure.
In the past two decades, however, the situation has changed. A
series of high profile legislative efforts by the European Commission,
ranging from the regulation of takeover bids to establishing new
business entities, ran into conflict with the European Parliament. What
explains the shift in legislative policymaking authority encountered by
EC? Influential theories of EU lawmaking emphasize that the policy-
making space became be very limited due to the mixed motives of
Member States (Pollack 2003). The presumption that Member States
should want to weaken, not strengthen the Commission’s company
law agenda, has led some scholars to entertain the possibility that
major company law reforms are not considered important enough for
member governments to mobilize resources to achieve legislative
compromises (Wouters 2000).
In order to regain significant agenda-setting powers and the
8 Gerard Hertig and Joseph A. McCahery
1
See Presidency Conclusions, Lisbon European Council of June 23-24, 2000
(available at http://ue.eu.int/en/Info/eurocouncil/index.htm).
2
See http://europa.eu.int/comm/internal market/en/company/company/news/01-
1237.htm).
3
Cases C-212/97 Centros Ltd. V. Erthvers-og Selskabbsstyrelsen, [1999] ECR I-
1459, [1999] 2 CMLR 551 (Centros); Case C-208/00, Überseering BV v. Nordic
Construction Company Baumanagement GmbH (NCC), [2002] ECR I-9919
(Überseering); and Case C-167/01, Kamer van Koophandel en Fabrieken voor
Amsterdam v. Inspire Art Ltd (NL), [2003] ECR 1 (Inspire Art).
These judgments are available at
http://europa.eu.int/cj/en/content/juris/index.htm.
Legal Options Approach to EC Company Law 9
With regard to established companies, the impact of the ECJ case law
is subject to debate, as it remains costly for them to switch from one
Member State regime to another. Nonetheless, these decisions have
increased the attractiveness of regulatory arbitrage which may make it
easier for corporations to select among legal rules from diverse
company law codes.
These disruptive features have induced the EC policymakers to
adopt a less constraining legislative approach. For example, the
Commission proposed - in a radical departure from its previous policy
-, that Member States be allowed to opt-out of Articles 9 (board
neutrality) and 11 (break-through rule) of the Takeover Bids Directive.
The proposal was received favorably by Member States, ending a
regulatory deadlock that had lasted for more than a decade. 4 The
Commission has subsequently created a large and growing number of
soft law initiatives that link together national governments’ and EU
policymakers’ concerns to succeed in transforming their relationship
concerning agenda setting and implementation of corporate law.
The provision of flexible corporate law rules has many
advantages. In particular, the greater range of choice in policy-making
instruments makes it easier to avoid the costs of relying on rigid
instruments alone. The Commission can choose to: 1) enact mandatory
EU provisions (as was generally done in the past); 2) offer Member
States a choice among a finite number of EU-defined options (an
approach originally adopted in the Accounting Directives); 3) enact
harmonized provisions, but empower Member States to opt-out of
them (an approach adopted by the Takeover Bids Directive); 4) enable
firms to opt out of applicable Member State provisions by providing
substitutable EU provisions (as was also done in the Takeover Bids
Directive); 5) adopt a EU regime that firms can opt-out of (which has
not been tried yet, but is in line with the flexible approach adopted by
the Takeover Bids Directive); and 6) and abstain from legislating.5
4
Directive 2004/25/EC, [2004] OJ L 142/12.
5
Furthermore, reformers can combine approaches. For example, the Takeover
Bids Directive allows Member States to opt-out of its board neutrality and prohibition of
10 Gerard Hertig and Joseph A. McCahery
defensive measures provisions, while enabling firms incorporated in Member states that
do so to opt into the EU regime. Or, to take another example, firms could be allowed to
opt-out of their domestic regime not only to escape mandatory provision, but also when
EU law has a standardization advantage over Member state default provisions.
6
Case 81/1987, Regina v. H.M. Treasury and Comm’rs of Inland Revenue, ex
parte Daily Mail and General Trust Plc, [1988] ECR 5483.
7
See Glenn R. Simpson, EU’s Tax Changes Scatter Corporations, THE WALL
STREET JOURNAL (European ed.), October 9, 2003 at A6.
Legal Options Approach to EC Company Law 11
no mean certain. Moreover, should the ECJ eventually do so, the main
beneficiaries (larger established companies) may be worse off from
changes in the status quo. Pro-taxpayer case law is likely to trigger tax
measures at the domestic and international level that could prove more
costly than the gains from greater freedom of movement (Hertig
2004). Hence, there is some evidence that Member States, in particular
the UK, systematically adjust their tax laws to minimize the impact of
ECJ judgments and that freedom of establishment case law is driven
by smaller rather than larger firms – an indication that the latter
generally do not expect to significantly gain from it.
This does not mean that only those firms that can afford
reincorporation will benefit from regulatory arbitrage and regulatory
competition in the corporate law area. The trend set in train by the
Centros, Überseering and Inspire Art judgments has directly
influenced the policy space of the European Commission. Hence, the
introduction of the new directive on cross-border-mergers,12 and
announced plans for a directive on the cross-border transfer of the
administrative office of firms can be considered as initiatives that
evidence the shift toward a mobility-oriented lawmaking agenda. In
addition, various Member States have responded to demands of
domestic firms for innovative company law terms. An ever-wider
array of Member States, such as Ireland, UK, Luxembourg and the
Netherlands, have prioritized the creation of corporate law rules that
directly benefit footloose foreign companies operating in other
jurisdictions. But others, France and Germany in particular, have the
more specific objective to make reincorporation in the UK less
economically attractive (see also Heine 2003; Vermeulen 2003). Given
these pressures, it now becomes easier to understand why EC
policymakers - with fixed positions - have agreed to adopt a new
legislative model that fosters diversity and allows (some) choice.
12
Directive 2005/56/EC, [2005] OJ L 310/1.
Legal Options Approach to EC Company Law 13
achieve the result. In some cases, this will require the creation of
stringent mandatory provisions, rather than defaults, in order to
constrain opportunistic behavior. Economic theory indicates that costly
opportunism typically occurs at the entry or exit stages. This means
that minority investors could be better off with a mandatory provision,
such as a fair value squeeze out rule, as a protection against
opportunism by controlling shareholders and managers. Some
commentators argue, moreover, that stringent mandatory rules can
protect entrepreneurs from early stage hold-up problems, which is
likely to promote social welfare by facilitating the absolute number of
start-ups (Hyytinen and Takalo 2005). What emerges from these
arguments is the observation that policymakers must, when designing
mandatory rules and legal options, find the proper balance between the
different interests and ensure that parties reach efficient agreements.
1. Mandatory requirements
As noted above, the introduction of default rules does not eliminate the
need for mandatory requirements to address contracting problems of
firms. A good example is corporate disclosure, an area in which
regulatory mandates have significant coordination and standardization
advantages. It is worth noting also that legal options may have to be
complemented by mandatory procedural rules (Hertig and McCahery
2004). In the next section, for example, we will show that EU opt-in or
opt-out provisions would make little sense as a governance mechanism
in controlling shareholders environments, unless reinforced by
mandatory approval requirements such as minority shareholder or
judicial ratification.
In recent years, the EU has adopted a fair number of
transparency requirements. Despite the demand for more disclosure
and the importance of such information for asset allocations, scholars
have questioned the effectiveness of these reforms without the creation
of an agency, such as a European SEC, to induce firms to make
reliable and accurate disclosure of financial and non-financial
information (Hertig and Lee 2003). Since none of the crucial
enforcement mechanisms or institutions are likely to be introduced in
the short term, it may not make much sense to propose new corporate
disclosure requirements that will end up increasing the cost to firms
and provide little additional information to investors.
Still, it appears that the mechanism of disclosure is particularly
crucial for investors, especially in light of the sequence of increasingly
blatant misinformation by public companies (culminating with the
Parmalat scandal), and the emphasis given by policymakers to it,
despite the absence of effective enforcement bodies, is understandable.
Hence, the EU has recently adopted new auditing standards as well as
requirements to rotate auditors on a regular basis and to designate a
single, fully responsible auditor for groups of companies.
Various commentators question the efficiency of some of these
new reforms for protecting the interests of investors. For example,
even though Italy has been the first (and only) Member State to
20 Gerard Hertig and Joseph A. McCahery
13
See Directive 2004/48/EC on the enforcement of intellectual property rights,
[2004] OJ L 195/16; Market Abuse Directive 2003/6/EC, [2003] OJ L 96/16.
22 Gerard Hertig and Joseph A. McCahery
hard stance will insure the adoption of an option that is close to their
own preferences. Unfortunately, the likely result will be a set of
options which has few benefits and thus all the more difficult to
justify. In addition, the existence of multiple options should increase
the petrifaction effect, as amendments would have to be coordinated
and should thus be more difficult to pass than when there is only one
mandate or one legal option. The potential weakness of the finite set of
competing legal options approach suggest that it is not ideally suited to
the current institutional and political environment and hence should
not be considered as a mechanisms for first step company law reforms.
3. Opting-out of EU provisions
14
Opposition will not necessarily be inexistent, as some Member States may fear
that the adoption of EU provisions may make opt-outs unsustainable in the long-term.
Legal Options Approach to EC Company Law 25
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Hyytinen, Ari and Tuomas Takalo (2005), Corporate Law and Small
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(2003), THE ECONOMICS OF THE PROPOSED TAKEOVER BIDS DIRECTIVE
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